Today’s post is about Warren Buffett’s views on how managers should be compensated.

First of all, their compensation should be tied only to the results of the operation they are in charge of and control. For example, it makes no sense to tie the compensation of Ralph Schey (who runs Cott Fetzer) to the results of Berkshire.

Secondly, if capital invested in an operation is high, managers are charged a high rate for incremental capital that they use. Conversely, they are credited with an equally high rate for capital that they release.

A meaningful hurdle rate on the earnings of additional capital employed is also set and compensation increases when the target is met. The calculation is symmetrical and if incremental investment yields are sub-standard, it will be costly to the manager.

Using this arrangement, managers have an incentive to send back to Berkshire any cash that they can’t employ advantageously.

The use of stock options does not really align management’s interests with that of shareholders. Rather, it is like a “Heads I win, tails you lose” situation.

Furthermore, the exercise price of the option does not increase to take into account the fact that retained earnings are building up in the company. Even if a manager adds absolutely no value to a company, a policy of low dividend payouts and compound interest will ensure that earnings (and subsequently share prices) increase.

You can even say that by withholding cash to the shareholders, the profit to the option-holding manager increases.

In all cases, Warren Buffett works out the compensation of his managers in a rational and simple way. There is no need of consultants or lawyers to work out complicated compensation plans. The compensation arrangement with Ralph Schey was worked out in about five minutes, and has never changed.

It has been a while since my last update as I had been busy with the Singapore elections. Don’t get me wrong; I was neither involved as a candidate nor a member of any political party. :)

Rather, I was reading the news and analysis by other bloggers. For a change, it was refreshing to read about some alternative views. There were also some in-depth articles which were much better than those in our local press.

Anyway, back to the Warren’s letter. This time round, I shall try to add in a bit of my writing style. (Past postings were mostly re-phrased from the actual letters.)

Limits of Growth

Anyone who has studied economics will know about the law of diminishing returns. The same principle applies when a company is growing. A company could be earning a very high return on equity. But as it gets bigger, it will have difficulty substaining this rate of return. “Growth eventually dampens exceptional economics.”

In such a case, the company could try looking for other business to invest in (often with disasterous effects) or return the surplus cash generated to shareholders.

Business Value Vs Market Value

The Efficient Market Hypothesis (EMH) says that securities will be appropriately priced and reflect all available information. Which means to say that the market value will be close to business value.

Warren believes that is far from the truth. In his own words, “the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.”

Of course, not forgetting three other points: the business must have fine underlying economics, an able management concentrating on the interests of shareholders, and a buyer willing to pay full business value at the time of divestment.

Shutdown of Textile Business

The unprofitability of the textile business was discussed previously. Rather than injecting huge amount of capital to keep it alive (which would have resulted in terrible returns on ever-growing amounts of capital), Warren decided to bite the bullet and shut down the business.

A few years ago, he wrote, “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” His views remain unchanged.

Another lesson learned during the diposal of the textile business was that the assets sold for much less than they were reflected on the books. If you are one of those investors who weigh book value heavily in your stock buying decision, make sure you don’t do it blindly!

Using Options as Compensation

A common argument in using options to reward management is that it puts them in the same boat as shareholders. Boat, yes. Same boat, no. Here are some reasons why:

2) Owners have potential upside rewards as well as downside risk, option holders have no downside.

3) The dividend policy of the company has an opposite effect on owners and option holders. For an option holder, he would prefer that no dividends are paid out so that the earnings (and share price) increase year after year.

Warren prefers using a system of cash reward pegged to performance. The managers can then use these money to purchase the stock of the company from the open market. By accepting both the risks and the carrying costs that go with outright purchases, these managers truly walk in the shoes of owners.